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© 2005 Real Options Group
Executive Training & Conferences
Real Options and Strategy
Lenos Trigeorgis
Objectives Why useful to know about real options Recognizing real options NPV and managerial flexibility Types of real options Valuing real options (principles) Competition & strategy Benefits of real options Areas of application
Flexible Plans
action plan
Expected plans
Time
Strategy
volatile marketsCurrent state Desired future states
Uncertainty
competition
Opportunities
new capabilities
flexibility
information
long-term strategy
Real Options/Flexibility Under Uncertainty
Example: Flexible Airline Ticket
right (but not obligation) to take a particular flight
pay more for an open ticket because it allows flexibility
- can change date of travel or destination
price difference between a flexible and fixed ticket reflects the
option value- additional value of flexibility to (adapt your plans to) changeflexibility
Recognizing Real Options
Real Options Ingredients
flexibility, choice or right (but not obligation) to do something (take a contingent course of action) only if beneficial
- upside-enhancing actions if circumstances prove favourable- downside loss-limiting actions if they prove unfavorable
specified cost to exercise the right
uncertainty - range of possible (value) outcomesoption ingredients
Recognizing Real Options
NPV and Managerial Flexibility
Traditional
Expected scenario of cash flows over prespecified life (discount ed at risk – adjusted rate, e.g., from
CAPM)
Treating projects as independent, make immediate accept/reject decision
I
k1
CEIVNPVE t
t
Ik1
CEt
t
rrrk M
NPV and Managerial Flexibility (cont.)
As if passive management; irrevocable commitment to implied “operating strategy” In reality, management can depart from original operating strategy/revise later decisions (e.g. defer, expand, abandon) Managerial flexibility as a collection of corporate real options Conventional NPV does not adequately account for options/flexibility due to discretionary character/ dependence on future events uncertain at present
Expanded (Strategic) NPV = Passive NPV + Real Option Value
Ik1
CEt
t
Traditional NPV: Limitations
Cannot properly account for active management (flexibility to adapt)
Ignores “strategic” value considerations
I
k1CE
tt
With uncertainty and managerial flexibility, NPV (DCF ) is inadequate to properly capture the asymmetries/ nonlinearities in the cash-flow distribution and the changing project risk profile or discount rates (across time and various states)
Managers understand resource allocation is a dynamic (and non-linear) process
Past Attempts toward Flexibility
Sensitivity analysis Scenario planning (correlated) Simulation (Monte Carlo) Decision (Tree) Analysis “Fudging” the discount rate in DCF Who sponsors (“champion”); “strategic” value
Incorporating Flexibility (Now)
Real options can capture the value of managerial operating flexibility and “strategic” value Real options can occur naturally or may be built in /acquired (at cost)
A firm may acquire real options through
Acquiring Real Options
Ownership of natural resources (real estate, oil field…) Technological Knowhow Reputation / Brand name Strategic alliances / Market position Organizational capabilities / Infrastructure, employees Intellectual property rights (patents, licenses,
leases…)
Some Common Types (Examples)
1. Defer 2. Staging/Abandon3. Expansion (Growth)4. Shut Down and Restart5. Switch (Operating Flexibility)6. Multiple Options (Portfolios)7. Interacting Options
Example 1 – Deferral Option(Oil company E&P license)
oil E&P license
Context- North Sea oil company acquired a number of licence blocks- E&P rights to explore and produce oil over next 8 years- at prevailing energy prices, most energy blocks unprofitable
(high development costs)
Categorizing (Common) Real Options
Example 1 – Deferral Option
Real Options Approach- some blocks may be uneconomic to develop now but could hold significant value in future should oil prices rise- oil company has flexibility to decide optimal timing to develop- develop (exercise option) when prices rise sufficiently to make production profitable
timing flexibility
Common Real Options
Example 1 – Deferral Option
development guidelines
DevelopmentRights
volatile oil pricesDevelop OperateOperate
INVEST
Common Real Options
Example 2 – Staging/Abandon Option
(Pharma R&D)
pharma R&D
Context
- Pharma R&D investment structured in multiple stages and full of uncertainties (a) technological uncertainty (to invent safe and effective products) (b) market uncertainty (probable demand for the drug)
Common Real Options
Example 2 – Staging/Abandon Option
Staging/gates
Stage 1:Initial
Research
Stage 2:Development/Clinical Trials
Stage 3:Marketing
Uncertainty: technologically feasible?
Uncertainty: safe product?
Uncertainty: demand for drug?
Yes YesYes
No
Launch Drug
Abandon Abandon Abandon
No No
Common Real Options
Example 3 – Expansion (Growth) Option
(Bookseller Online)
Context- leading retail bookseller interested in selling products online- company excited about the spectacular growth of the Internet but unsure about the economics (early online retailers have seen spectacular growth but also low negative cash flows)- potential for cross selling into other areas (music, software…)
B2C eCommerce
Common Real Options
Example 3 – Expansion Option
expansion policies
Retail book sales
Sell BooksOnline
Sell Software
Online
Sell MusicOnline
Uncertainties: Demand growth?Competition?Capability?
Exercising the first option opens up numerous cross-
selling options
Common Real Options
Example 4 – Shut Down & Restart Option
(Energy Co’s Peak Power Plants)
peak power
Context - US energy company investing in new, inefficient peak power plants
(have 50-70% above-average marginal costs)- cheaper to build than more efficient plants
- peaking plants extremely profitable in short periods when electricity prices peak
- extreme volatility in power prices (can vary from $40 to $7000/MWh)
Common Real Options
Example 4 – Shut Down and Restart
Operating guidelines
OperatingRights
volatile electricity pricePowerOn
PowerOn
PowerOn
Common Real Options
marginal cost
Example 5 – Switch Option(Multinational Auto Production)
auto production
Context- US-based multinational auto producer considering where to base Latin American production facilities supplying region- concerned about exposure to
- exchange rate fluctuations- changing labor costs and tax policies - political uncertainty
Common Real Options
Example 5 – Switch Options
switch triggers
Produce Cars in Brazil
Uncertainties: Exchange Rate?Labor costs?Govt policies?
Switch toArgentina
Common Real Options
Example 6 – Multiple (Portfolio) Options
(Venture Capital)
venture capital
Context- Venture Capitalists manage portfolios of many investment opportunities- Each individual opportunity has a small chance of a very high payoff (with expected return close to zero)- Portfolio provides handsome returns (25-35%) due to flexibility to abandon failing projects while expanding successful ones as uncertainty about the venture gets resolved
Common Real Options
Example 6 – Multiple (Portfolio) Options
portfolios
ROI
Project 1
Project 2
Project 3
Project 4
Project 1
Project 2
Project 3
Project 4
Ideas
Terminated
Successful venture (exit/ sale)Breakeve
n
t=0 t=1 t=2
OPTION TO EXERCISE Usual VC Statistics
10% Success60% Breakeven30% Failure
Biz Plan
Option 1Option 2Option 3
25-35% ROI
Expected distributionof outcome for anindividual venture
Expected distribution of outcome for a VC portfolio
Common Real Options
0
trigger states
Un
cert
ain
un
der
lyin
g v
alu
e
unfavourable
Favourable
developments
Expand
Continue
Abandon
Time
Action Plan
Understanding Real Options
Options /Asymmetry in NPV Distribution
Ik1
CEt
t
Call Options on Stock vs. Real Options
Stock Call Option
Stock price
Exercise price Time to expiration
Stock return volatility Riskless interest rate Dividends
Real Option
(Gross) PV of expected cash flows Investment cost Time until opportunity disappears (patent, compet. entry)Project value (%) uncertainty Riskless interest rate Early operating cash flow or competitive erosion
Industry Volatility and PVG0/Price for Representative Industries
INDUSTRYPVGO/P
Market Model Risk free rate +6% premium
84% 83%
92% 83%
83% 70%
62% 38%
46% 47%
60% 48%
81% 72%
81% 55%
Information Technology 23%
Pharmaceuticals 14%
Consumer Electronics 26%
UNCERTAINTY2)
Transportation 9%
Chemicals 6%
Electric power 4%
Food 6%
Banking 6%
Source: Smit & Trigeorgis, Risk (1999)
Note: Volatility ( 2 ) is estimated as the variance of monthly returns; PVGO is
estimated by subtracting the discounted value (with the discount rate estimated from the market model or the risk-free rate plus a 6% risk premium) of its perpetual stream of earnings (under a no-growth policy) from its market price (6/30/98)
Opportunity to invest I = $104 (m) in a project (plant) that a year later (at t = 1) will have realizable value of either V+
= $180 or V- = $60(k = 0.20, r = 0.08)
Valuing Real Options/Principles
A Generic Example
V= 100
V += 180
V -=60
q=0.5
0.5
Under traditional NPV, gross value of project´s cash inflows
V = [q V+ + (1 - q) V- ] / (1 + k) = [.5 x 180 + .5 x 60] / (1 + .20) = 100
Generic Project and “Twin Security”
V+=180, S+=36
V-=60, S-=12
V=?, S=20
q=0.5
1-q=0.5
I=104, k= 20% (CAPM), r=8%
t
t
k
CV
)1(V: PV of project´s expected cash inflows S: “twin security” priceI: required investment outlay E: value of investment opportunity to firm´s equityholdersk: discount rate (expected rate of return)r: risk–free interest rate
NPV = V-I
1-p
p=0.4 V+=180
V-
=60
V=100
Note also that (with risk-adjusted probability, p) V = [p V+ + (1-p) V-] / (1 + r) = [.4 x 180 + .6 x 60] / (1 + .08) = 100 (same) Passive NPV = V – I = 100 – 104 = -4 (<0) Reject? Expanded (Strategic) NPV = Passive NPV + Real Option Value
Risk-adjusted Probabilities
u=1.8
d=0.6
V+=180
V-=60
V=100
S+=36
S-
=12
S=20
E(R) = r p.u + (1-p).d = 1+ r
p = [(1 + r) - d]/(u - d) = = [1.08 - 0.6]/(1.8 - 0.6) = 0.4
p.S+ + (1-p)S- = S(1+ r)
p = [(1 + r)S - S-]/(S+ - S-) = [1.08×20-12]/(36-12) = 0.4
Option to Defer
Suppose the firm has a one-year license (patent/lease) giving it exclusive right to defer for a year
Call (E)180-112=68
1-p
p=0.4
t =0I=104
V=100
V+=180
V-=60t=1
Like call option on project value V with EX = I1 = 112(with I0 = 104 assumed to grow in one year at 8% to I1 = 112)
E+ = max (V+ - I1, 0) = max (180 – 112, 0) = 68 (invest)E- = max (V- - I1, 0) = max (60 – 112, 0) = 0 (do not invest)
0
With p = [(1 + r) S – S-] / (S+- S-) = [(1.08) 20 – 12] / (36 – 12) = 0.4 (vs. q = 0.5) Total value of investment (expanded NPV with option to defer): E0 = [p E+ + (1 – p) E-] / (1 + r) = [ .4 x 68 + .6 x 0] / 1.08 = 25 Real Option Value (defer option/lease) = Expanded NPV – Passive NPV
= 25 – (-4) = 29 (% of V)
Option to Expand (Growth Option)
p=0.4
1-p
V=100
V+=180
V-=60
Consider additional follow–on investment (expansion) if product does better
Original investment opportunity thought of as initial (base) scale project plus call option on future (expansion/growth) opportunity: V + max(eV – Ie, 0) Option to invest additional Ie= $80 next year
which would double scale and value of project/plant (e = 1) Now E = V + max(V - Ie, 0) = max(V, 2V - Ie)
V=100
V+=180
V-=60
E+ = max(V+, 2V+ - Ie´) = max(180, 360 – 80) = 280
(expand/double scale) E- = max (V-, 2V- - Ie
´) = max (60, 120 – 80) = 60 (same/base scale) Value of investment opportunity (with follow on option to expand): E0 = [p E+ + (1-p) E-] / (1 + r) – I0
= [.4 x 280 + .6 x 60] / 1.08 – 104 = 33 Option to expand = 33 – (-4) = 37 (or 37% of V)
$104 { Ic = $58 (FV of $54) in year t = 1 Option to abandon project at t = 1 or halve scale (c = 0.5) and value of project by defaulting on I c= 58
Options to Stage/Abandon & Contract
Option to stage investment and abandon midstream, or contract scale of project´s operation by forgoing planned expenditures if product does poorly
Seen as put option on part (c%) of project (V) that can be contracted or abandoned (V – Ic ) + Max(Ic – cV, 0) = Max(V – Ic, (1-c)V)
I0 = $50 now
0.6
p=0.4V+=180
V-=60
E+ = max(V+ - Ic, 0.5 V+) = max(180 – 58, 90) = 122 (continue) E- = max(V- - Ic, 0.5 V+) = max(60 – 58, 30) = 30 (contract/abandon) Investment opportunity (with option to contract or abandon): E0 = [.4 x 122 + .6 x 30]/1.08 – 50 = 12 Option to contract (default) = 12 – (-4) = 16
0
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Notes:1. In August 1995 Netscape goes public in providing software for the Internet (all firms indexed at 100 on 8/9/95).2. In March 1997 Microsoft allies with rival Hewlett-Packard to push its Windows NT program into corporate servers. 3. In April 1997 Microsoft agrees to buy WebTV, a start-up company that delivers Internet information directly to television sets.4. In May 1997 Microsoft announces an all-out attack into the lucrative heavy-duty corporate computing market.5. Also in May 1997 Oracle buys into Navio Communications, established by Netscape to develop Internet software for consumer electronics.6. Netscape and Microsoft make further strategic moves to gain an advantage in their continuing battle over who will be the Internet standard bearer. Through its superior strategic moves Microsoft gains a clear advantage over Netscape whose relative position is eroding.
A. Software
Microsoft´s strategic moves and superior market performance
over Netscape and other computer software rivals
Competitive Strategies and Relative Market Performance for High-Tech Firms
1
Microsoft
S&P 500 Computer IndexOracle Corp.
Netscape Communications
2 4
5
6
3
COMPETITION & STRATEGY
1. High-tech firm with 1-yr license to wait for commercial production2. Impact of exogenous competitive entry (“dividends”)3. Early investment to preempt (two-stage investment)4. Should it invest in R&D to acquire proprietry option to invest in more cost-effective commercial production in stage 2?5. Impact of endogenous competition in production (stage 2) What difference if proprietary vs. shared benefits, contrarian vs. reciprocating competitive reaction?6. What if compete in R&D (stage 1) sequentially (innovation race with first-mover advantage?). What if both invest simultaneously and get hurt?7. Benefits of cooperating in R&D?
Passive NPV
V=100
q=0.5
1-q=0.5
V+=180
V-=60
Invest now (commitment value) = NPV = V – I = 100 – 80 = 20 (>0)
I=80
Investment cost: I = 80 Risk neutral prob.:
Discount rate: k = 0.20 (Gross)Project value: Risk-free rate: r =0 .08
Actual probability: q = 0.5
10008.1
606.01804.0
1
)1(
r
VpVpV
4.0)1(
VV
VVrp
No flexibility to deviate from expected: Invest Now
Proprietary Opportunity (license)
Wait to invest under uncertainty
V=100
V-=60
V+=180q=0.5
1-q=0.5
C
C+=Max(V+-I,0) (Invest) =180 – 80 = 100
C-=0 (Do not invest)t =0 t =1
I=80
Opportunity to invest provided by license (call option): C
p C 1 p C
1 r
.4 100 .6 0
1.0837
Shared Opportunity
Invest now if can preempt competitionA. Impact of exogenous competitive entry: reduced option value (50% cash-flow “dividends”)
V=100
V+=180
V-=60
(V+)’=90
(V-)’=30
Wait (call option with “dividends”):
(half of 37) C'. ( ) .
..
4 90 40 6 0
108185
p=0.4
1-p
(C+)’=90-40=50
(C-)’=Max(30-40,0)=0
Shared opportunity
B. Invest now/ exercise early (e.g., build excess plant capacity) to preempt competitive erosion or capture cash-flow “dividends”
Invest now if can preempt competition
Invest now: V - I = 100 - 80 = 20 (> 18.5)
V+=180
V-=60
V=100
Simultaneous Investment Timing Game
Compete/invest early (prisoners’ dilemma)
B
Wait Invest
Wait
Firm A
Invest
(18.5,18.5)
(10,10)*
Invest
WaitA
Firm B
B
Invest
Wait
(0, 20)
(20,0)
(18.5,18.5)
Invest
Wait
Extensive form
(share NPV=20)
(share 37)
(10,10)*(20,0)
(0,20)
A: Invest regardless of B (dominant) B: Invest regardless of A
But better if wait
Two-stage (Growth) Investment R&D/ infrastructure/ growth option
V++ = 324
V+- = 108
V-- = 36
V+ = 180p=0.4
V = 100
1-p
V- = 60II = 30 III = 80
t = 0Stage I Stage II
t = 1 t = 2
NPV NPV NPV I II
30 80
1.08
.5 180 .5 60
1.20
30 ( )74 100 30 26 4 0
NPV NPV Option * I II
30 . ( ) .
1.08
4 180 80 6 0
30 37 7 0
Competitive Strategies (Dog)
Contrarian Reciprocating
flexible and inoffensive commiting and offensive
flexible and offensive commiting and inoffensive
COMPETITION
PIONEER (A)
Proprietary (capture most of
total market value)
Shared
Preemptive commitment (+) effect
Vulnerable (-) effect
Non-provoking (-) effect
Cooperative commitment (+) effect (+) effect
(fixed market value)
e.g., Quantity competition
(altered market value) e.g., Price competition
(share total market value)
1 2
4 3
Depend on type of investment (proprietary vs. shared) and competitive reaction (contrarian vs. reciprocating)
Proprietary (2/3) / Contrarian (1) Invest in R&D (offensive strategy to preempt )
Wait Invest
Wait
Invest
(10,0)*
(0,-20)
1
4
(0,-20)
2
(-20,0)
3
High Demand (V+=180) Low Demand (V-=60)
Wait Invest
Wait
Invest (100,0)
(0,100)(81, 25)
(80,20)*3
21
4
Nash (A invest, B invest);
IIA = 30; III
A = 40; III = IIIA + III
B = 80 (if preemption IIIA = III
B = 80)
5353008.1
106.0804.030NPV*
A
NPV 0 0.4 20 0.6 0
1.08 7B
*
Firm A
Firm B
*
*V
V -
V +p
1-p
Proprietary (2/3) / Reciprocating (-1/4)
Do not invest in R&D (avoid rivalry and price war)
Wait Invest
Wait
Invest
(10,0)*
(-10,-25)
1
4
(0,-20)
2
(-20,0)
3
High Demand (V+=180) Low Demand (V-=60)
Wait Invest
Wait
Invest (100,0)
(0, 100)(61,15)
(50,5)*3
21
4
*A
0.4 50 0.6 10NPV 30 30 24 6 0
1.08
21.08
00.650.40NPV*
B
A
B
Shared (1/2) / Reciprocating (+1/4)
Invest in R&D (expanded pie from coordination)
Wait Invest
Wait
Invest
(10,10)*
(-3,-3)
1
4
(0,-20)
2
(-20,0)
3
High Demand (V+=180) Low Demand (V-=60)
Wait Invest
Wait
Invest (100,0)
(0, 100)(75,75)
(73,73)*3
21
4
Nash (A invest, B invest) Shared (coordination): wait
NPV . .
.A*
300 4 73 0 6 10
10830 33 3 33330NPV*
B
A
B
Shared (1/2) /Contrarian (1)
Do not invest (avoid subsidizing aggressive rival)
Wait Invest
Wait
Invest
(5,5)*
(-10,-10)
1
4
(0,-20)
2
(-20,0)
3
High Demand (V+=180) Low Demand (V-=60)
Wait Invest
Wait
Invest (100,0)
(0, 100)(53,53)
(50,50)*3
21
4
*A
0.4 50 0.6 5NPV 30 30 21 9
1.08
21210NPV*B (< 0);
A
B
Sequential R&D Investment Race
Invest to preempt (first mover 2/3 or time-to-market)
BWait Invest
Wait
Firm A
Invest
(16,16)
(22,-17)
1
4
A invests; given that, B waits Winner takes all
(0, 35)
2
(35,0)*
3
(22,-17)
Invest
WaitA
Firm B
B
Invest
Wait
(0, 35)(35,0)
(16,16)
Invest
Wait
1
2
3
4
Simultaneous R&D Investment Battle
Invest prematurely (prisoners’ dilemma)
Firm BWait Invest
Wait
Firm A
Invest
(16, 16)
(2, 2)*
1
4
(35, 0)
3
2
(0, 35)
Invest prematurely; both get hurt (worse than wait)
Cooperate in Technology Investment
Joint R&D Ventures
Firm BWait Invest
Wait
Firm A
Invest
(22,22)*
(17,17)
1
4
Save (share) costs; better appropriate (jointly)
option value of waiting
Benefits of Real Options Valuation
Helps systematize the analytical process Structures problem to uncover important aspects
and provide deeper insight · Focuses on the primary uncertainties and value
drivers· Captures the value of optionality and strategic
thinking Much benefit derives from the structuring process
itself (beyond the evaluation results)
Provides a common language for communication among
different functions (R&D, finance, strategy, marketing)
Provides intuition, that may sometimes challenge conventional thinking, e.g.,
• Higher volatility may increase value• Accepting negative-NPV projects or delaying positive-
NPV ones may be rational/justified Provides better interface between capital budgeting,
strategic planning, incentives and control systems
AREAS WITH USEFUL OPTION APPLICATIONS
R & D (new products/processes) & innovation
· Industries: high-tech, computers & semiconductors, pharma, bio-tech, chemicals, other growth industries with multiple stages, product generations or applications
· Options: staging (time-to-build) and growth/expansion options (multi-staged investment)
Infrastructure (platform/capabilities)
Info.-technology network (e.g., to develop capabilities to expand
more efficiently), ports/airports/railroads/road network, power plants (e.g., electricity), corporate core capabilities to adapt
. Industries: transportation, info./telecom, energy etc. · Options: compound options, portfolios of options
Strategy and competition
Growth options to acquire foothold in new/foreign markets (e.g., in Greece to enter EU), sourcing/multinational network operations (switch labor, exchange rates, human capital), strategic acquisitions (new market or technology), goodwill/brand name, joint ventures to build network/ relationships (e.g., in India, China), patent races/product standard
Industries: new/foreign/emerging markets, M&As, goodwill intensive, electronics, pharmaceuticals, detergents, airlines etc
· Options: growth (compound)/expansion options, abandonment options, switch/exchange options, competitive games etc.
Flexible manufacturing (multiple inputs/outputs)
• Industries: energy (e.g., power plants using diverse
fuel inputs), autos (CAD/CAM), toys, consumer electronics, fashion, info. technology, flexible publishing
• Options: options to switch/exchange
Intellectual/property rights
Patents, leases, movie rights, software licenses, goodwill/ brand name etc.
· Industries: high-tech, pharmaceuticals, biotech, software, media/entertainment, publishing etc.
· Options: wait to invest, compound/expand options etc.
Performance measurement/compensation
Develop more dynamic economic value added (EVA)–like measures consistent with option-based expanded-NPV, integrating capital budgeting with strategic planning and control; develop conditional control targets (e.g., ROA, growth) contingent on exercise of major future options; recognize agency conflicts (e.g., expansion) and distortions in optimal exercise policies and design corrective incentive contracts
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